Richard L. Thomas Professor of Leadership and Organizational Change; Co-Director, Northwestern Institute on Complex Systems (NICO); Professor of Industrial Engineering and Management Sciences, McCormick School (Courtesy); Professor of Sociology, Weinberg College (Courtesy)
After a grueling fourteen-hour day spent tracking down shipments in Peru, a logistics consultant and her client head to a restaurant for ceviche. An accountant takes a phone call at his son’s hockey game because he knows the client needs tax-time expertise. These commonplace scenarios illustrate the popular belief that personal relationships go a long way in determining winners and losers in the business world. Although such social influences are commonly recognized, they have been surprisingly under-studied by economists. Brian Uzzi (Professor of Management & Organizations at the Kellogg School of Management; Professor of Sociology at Northwestern University) and Ryon Lancaster (Assistant Professor of Sociology at the University of Chicago; graduate of the Kellogg School and Northwestern University’s joint Management & Organizations and Sociology program), writing in American Sociological Review, show how social interactions influence the prices of corporate transactions.
Sociologists and Economists Weigh In
“Going back about ten years, sociologists put a lot of emphasis on social networks in explaining people’s behavior, while in a neighboring social science field, economics, it was completely the opposite: each person was considered an atom,” said Uzzi. “The deep sociological idea was that who you are and what you do is related to the network you’re in. But in economics, all decisions were assumed to be made in isolation. One side tried to show that networks matter, another tried to show that networks didn’t matter.
“Finally,” said Uzzi, “I reached a point where I had to say, ‘If we take this debate between economics and sociology seriously, we need to show that networks affect the one thing that economists care about more than anything else in the world: prices.’”
From a sociological perspective, informal social relationships are thought to shape our economic opportunities in ways that impersonal market interactions and formal contractual relationships do not, by providing access to unique information and business arrangements. This embeddedness of individuals within social networks can reduce the uncertainty in and decrease the costs of transactions between individuals, improve differentiation of products, and lead to more rewarding consumption.
The Search for Data
Price information is ubiquitous, ready in abundance and waiting for curious economists to measure and model. In business pages and produce aisles, government tables and corporate bottom lines, prices are listed everywhere. But social networks, by their very nature, are informal and “off the record,” so they are not nearly as easy to catalog, quantify, and correlate.
“Prices are public, but most people keep their networks private. Where are you going to find data on prices and networks?” said Uzzi. Fortunately, he and Lancaster had to look no further than a few miles south of the Kellogg School’s Evanston campus to Chicago, where large law firms networked and billed in prodigious fashion. Many lawyers at those firms took classes at the Kellogg School or were alumni of Northwestern’s School of Law and were willing to share their insights and valuable time.
The last decades of the twentieth century saw the emergence of so-called “mega” law firms, which wield broad expertise and substantial staff sizes and provide expert, complex legal services to large, diverse corporations. A survey showed that from 1989 to 1995 the smallest 20 percent of U.S. mega firms employed an average of 267 attorneys spread across four or five offices, while the largest 20 percent employed an average of 510 attorneys across ten or eleven offices. Billing rates for partners at the smallest firms averaged from $173 to $309 per hour, while the largest firms averaged $190 to $350 per hour for a partner’s time.
“Large law firms came to Kellogg to learn, looking more like large corporations than ‘mom-and-pop’ law firms,” recounted Uzzi. His conversations with the mega-firm lawyers proved extremely insightful. “These data are open to many different interpretations,” he explained. “By talking with practicing lawyers, we learn which interpretation of the results makes most sense in light of what the practitioners actually do. It’s like having different methods to triangulate, several different eyewitnesses.”
Uzzi and Lancaster interviewed full partners and younger associates at mega firms, asking them about partnerships and efficiency, profitability and client development, pricing tactics, and ties between firms. They also interviewed banking and insurance executives who work with their in-house lawyers to hire law firms.
Social Features That Influence Fees
These interviews helped Uzzi and Lancaster generate hypotheses about how certain social features might influence fees firms charge for their services. To test those hypotheses, they devised statistical models that incorporated quantitative data regarding firms’ pricing and personnel, their ties with clients, and their reputation. Specifically, they modeled three features: how firms’ prices changed with respect to the number of embedded ties they had with clients; the number of the firm’s attorneys who sat on the boards of other corporations; and the status of the firm as perceived by peers.
The greater the proportion of informal relationships and unwritten arrangements a firm enjoyed with clients, the lower the fee the firm typically charged for complex legal work. Such ties promote clearer understanding of client needs and preferences and lessen the need for rigid oversight structures, allowing for more efficient and timely operation, thus requiring less billable time from a firm. Said one partner: “It’s no question that trust enters into [pricing]. I mean, it’s very rare that you’re going to get the big $500 million transactions—I don’t see them with a stranger.” Said another: “A relationship allows [the client] to be more nimble with our firm; rather than having a formal engagement in a project, she may call a partner she knows directly—so it’s very efficient for her.”
Besides promoting the flow of private, valuable information between firm and client, network ties can give the firm access to useful information flowing between other parties. In particular, a firm can benefit significantly if its attorneys sit on corporate boards. One attorney described two notable advantages of board membership this way: “You have the benefit of seeing what other law firms are charging if the company that you sit on is using other firms. . . . And you get the benefit of the commentary that your fellow board people have on legal services and what they consider to be important.” As a result of this privileged information, firms whose partners sit on corporate boards are able to charge higher rates for both routine and complex legal work.
Law firms perceived to have high social status are able to offer image-enhancing benefits to its clients, since the clients will appear knowledgeable about securing quality legal services. Use of a high-status firm also reduces uncertainty in future transactions with the firm’s attorneys, making the project less costly to govern. Said one attorney: “I could get this [legal expertise] somewhere else. I can use a medium-size firm in Kentucky, and they’re fine. But I’d like to be able to tell my directors I got . . . a high-status firm. There’s less to justify before the deal and after the fact if something goes wrong.” As a result, an elevated perceived status means a firm can charge higher fees, especially for more complicated legal work.
Of the three features investigated in their model, Uzzi and Lancaster showed that status had the greatest effect on price. A one-standard deviation improvement in perceived status increased the hourly partner rate by $9.41. Such a degree of improvement could be achieved, for example, if the firm that had been rated the eightieth best of one hundred firms rose in the rankings to become the fiftieth best, or if the firm ranked fiftieth rose to the sixteenth rank. Although increases in basic production costs were the primary drivers of higher prices, the effect of enhanced status was comparably strong, raising prices 73 percent as much as production costs did.
“Law firm prices are affected by public information: law firm rankings, reputation. Everyone has access to this information. This confirms commonly held economic beliefs,” said Uzzi. “But private information, unevenly distributed in the market, also influences prices. A firm’s social networks—for example, how many of its clients sit on corporate boards—also influence pricing. On the margin, private information that isn’t available to the average person can make a difference.”
Uzzi and Lancaster identified and demonstrated the effect of several key network structures. But their work has not yet revealed what actually happens between the time individuals gain private information through the network and when they set their prices.
“We would like to be able to track people so that as soon as they got private information, you’d see how their pricing changed,” Uzzi continued. To address this issue, he is currently conducting research with Kathleen Hagerty, Kellogg’s Senior Associate Dean for Faculty and Research. “We’re looking at e-mails that commodities traders send back and forth immediately prior to making their pricing decisions,” he said.
As long as business is conducted among human beings, and as long as people continue to be extremely social animals, informal personal relationships are bound to play a role in economic transactions. By showing how different social connections influence how prices are set, Uzzi and Lancaster provide a solid foundation upon which future work can build. Such work might help redefine how business structures and transactions are negotiated, organized, and executed. At the very least, it might help busy professionals rethink their Rolodexes. Said Uzzi, echoing with statistical certainty the wisdom of generations of businessmen and women: “Some contacts lead to better outcomes than others.”
Uzzi, Brian and Ryon Lancaster (2004). “Embeddedness and Price Formation in the Corporate Law Market.” American Sociological Review, 69: 319-344.